States put Centre in the shade

Mythili BhusnurmathOct 29, 2007, 01.13am IST

One of the most remarkable success stories in recent times is the transformation in state government finances. Over the past few years, as attention has shifted from fiscal to monetary policy, thanks in large part to strong dollar inflows, fiscal issues have increasingly been relegated to the backburner.

The result has been endless debate about how to manage money flows, effectiveness of monetary policy instruments, glitches in the transmission mechanism and so on even as fiscal issues are relegated to the backburner.

Part of the reason is that the battle on the fiscal front, while not yet won, is going more or less as planned. Till less than five years ago, almost every macroeconomist in the country obsessed about the state of the fisc, both at the Centre and at the states.

Then came the fiscal responsibility legislation of 2003, the dramatic pick-up in the growth rate (with burgeoning tax revenues), decline in interest rates and in the case of the states, the report of the Twelfth Finance Commission. And slowly, but surely, all levels of government have shown remarkable improvement in the health of their finances.

Nowhere is this improvement more marked than in the case of state governments. Indeed, contrary to general view of the states as laggards, it is no exaggeration to say the states have out-performed the Centre in getting their finances in order. This is so, not only in terms of getting their fiscal and revenue deficits down, in some cases ahead of the deadline, but also at a disaggregated level in terms of the quality of their spending.

Consider: State governments actually borrowed less in 2006-07 as compared to the previous year. As against a gross borrowing of Rs 21, 729 crore in 2005-06 they borrowed only Rs 20,825 crore during 2006-07. Better still the entire amount was raised from the market through the auction route as compared to 48.5% the previous year. Sure, the weighted average yield did move up in line with the hardening of yields across the board. But the weighted average yield on state government securities went up by only 47 points. In contrast the weighted average yield on central government securities increased by 55 points.

As at the end of March 2007, 70.3% of states' outstanding debt stock was at less than 9%, compared to 65.6% a year ago, with two-thirds in the 6-10 year maturity bucket. Comparable numbers for the Centre are: 63.2% of outstanding debt at less than 9% with 74% having maturity over five years. Given the in-built bias towards higher yields on state government loans as compared to central loans (since the Centre is the sovereign and can issue currency), the greater success of the states vis-a-vis the Centre in bringing down the share of high cost debt is no mean achievement.

Eighteen state governments have set up Consolidated Sinking Funds and eight have set up Guarantee Redemption Funds to meet repayment obligations and liabilities on account of any guarantees invoked. The consolidated balance in both funds, Rs 15, 015 crore and Rs 2,481 crore respectively, is fairly small.

But it marks a beginning in instituting the healthy practice of setting aside some money to meet future liabilities. More importantly, this is something that the Centre, for all its lip service to the cause of fiscal discipline, is yet to do. Tamil Nadu and Rajasthan actually prepaid their entire outstanding power bonds, issued in terms of the recommendation of the Montek Ahluwalia expert group on SEB dues.

According to a recent IMF study the quality of spending has also improved. With the exception of Himachal, the ratio of capital outlay to GSDP (gross state domestic product) has improved in 2006-07 (revised estimates) compared with the 2002-03 to 2004-05 average, with states like Bihar showing a three-fold increase.

Similarly a majority of the states have shown an increase in the ratio of social sector expenditure to GSDP as well as total expenditure. Clearly, the improvement in deficit indicators has not been at the cost of either capital outlays or expenditure in social sectors.

Take a state like Orissa, usually in the news for all the wrong reasons, floods or starvation deaths or the death of tribals. Yet it's been a path breaker in fiscal correction with many innovative schemes. For instance, it has adopted a zero-based investment review where each department assesses and prioritises all projects under four categories, varying from those that must be put on a fast track to those that can be scrapped. Orissa is not alone. Many other states have been as proactive.

Unfortunately just when they should be reaping the benefits of their fiscal prudence, the Centre, instead of making it easier for them, seems all set to undo the good work with irresponsible election giveaways like the Sixth Pay Commission award. It should think twice before it does so. In the late 1990s, implementation of the Fifth Pay Commission award saw states' establishment expenditure jump 75% in just two years, causing irreparable damage to their finances. Do we wish to set the clock back on all the progress that has been made since?